Risk Management in the Alternative Investment Fund Managers Directive (AIFM) by Alto Advisory, a Luxembourg based company

1. Risk Management in the AIFM Directive
Alternative Investment Funds / AIFMD
2010-12-15

2. Alternative Investment Funds Management Directive (“AIFMD”)
• New European Directive being prepared on Alternative Investment Fund Managers
(“AIFM”) to reduce investors and systemic risks linked to Alternative Investment Funds
(“AIF”)
• Applies to Managers of AIF established in the European Union (EU) or managing EU
AIF
• Defines rules on Authorization, Operations, Depositary Role, Transparency, Leverage
and Marketing of AIF
• Includes a lighter regime for leveraged funds below 100MEUR Assets and non-
leveraged funds with below 500MEUR Assets and 5 years lock-up
• AIFMD approved by European Parliament on 11/11/2010, with formal approval
expected in 2010. The Directive is the 1st level measure that will lead ultimately to
an implementation into national law expected around 2013
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Risk Management in the Alternative Investment Fund Managers Directive

3. Risk Management in the AIFM Directive
• While recognizing that AIFM were not the cause of the recent crisis, the EU
Commission aims to strengthen the AIF industry and in particular against 6 main
forms of risks:
▫ Macro-prudential (systemic) risk ▫ Market efficiency and integrity
▫ Micro-prudential risks ▫ Impact on market for corporate control
▫ Investor protection ▫ Impact on companies controlled by AIFM
• This objective is in particular implemented through a set of principles and
requirements for Risk Management practices for AIFM to follow:
▫ Chapter III, Operating conditions for AIFM
 Art. 11, Risk Management, including adequacy of systems, procedures and organization
 Art. 12, Liquidity Management, including adequacy systems and procedures
 Art. 18, Delegation, including conditions to delegate Risk Management
▫ Chapter IV, Transparency Requirements
 Art. 20, Disclosure to investors,
 Art. 21, Reporting obligation to competent authorities
▫ Chapter V, Obligations regarding AIFM managing specific types of AIF
 Art. 23, Disclosure to investors
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Risk Management in the Alternative Investment Fund Managers Directive

4. AIFMD – Article 11, Risk Management
 Separation of Risk Management and Portfolio Management functions
 Implementation of risk management systems to measure and monitor all risks to with the AIF is
or can be exposed
 Implementation of a due dilligence process for investments
 Identification, measurement and monitoring risk associated with each investment position at any
time, including through stress testing
 Correspondance between the risk profile and the AIF documentation and regulation
 In the case of short selling, procedures to manage delivery of sold instruments
Our analysis: Given the extent of the guidelines to orgarnization, procedures and systems, the
implementation of this article is likely to represent a significant challenge for AIFM and persons in
charge of Risk Management.
The article emphasis on “how” risk management should be conducted within AIFM might require
reorganization to avoid conflict of interests and implementation of complex systems and
procedures in areas that were previously far less regulated.
Although further level 2 and 3 measures will provide further details on the practical
implementation of the directive and most probably a convergence towards UCITS regulation, we
strongly recommend AIFM to start preparatory work on risk aspects now.
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Risk Management in the Alternative Investment Fund Managers Directive

5. AIFMD – Article 12, Liquidity Management
 Appropriate liquidity management system and procedures to ensure liquidity profile complies
with the AIF obligations
 Regular stress tests to be conducted to monitory liquidity risks
 Redemption policy needs to be appropriate for liquidity profile of the AIF
Our analysis: In addition to eventual redemption policy changes, the implementation of this
article requires a formalized management of liquidity including the setup of appropriate systems
and procedures. It will in particular require the setup of tools monitoring funding, assets liquidity
and redemption patterns.
AIFMD – Article 18, Delegation
 Like for portfolio management, delegation of risk management can only be made to a 3rd
Party authorized as AIFM. Regular service reviews required.
 Supervision duty of AIFM must not be impaired by delegation
 Delegating AIFM in charge of demonstrating suitability of the delegation
Our analysis: The implementation of this article will require formalization of the delegation
choice including due dilligence process, service levels definitions, escalation process and regular
service reviews performed
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Risk Management in the Alternative Investment Fund Managers Directive

6. AIFMD – Article 20, Disclosure to Investors
 In the prospective documentation: Description of all risks associated with the investment policy
of the AIF and description of liquidity risk management
 Regular disclosure of % of illiquid assets and description of liquidity risk management
 Risk profile of the AIF and the risk management systems
AIFMD – Article 21, Reporting to Competent Authorities
 Regular disclosure of % of illiquid assets and description of liquidity risk management
 Risk profile of the AIF and the risk management systems
AIFMD – Article 23, Disclosure to Investors for Leveraged AIF
 Disclosure of maximum leveraged the AIF may employ
 Quarterly disclosure of total leverage for each AIF in the quarter
Our analysis: With the exception of the disclosure requirement of Article 23, the implementation
of those requirements is linked to implementation of Article 12. It will however require a precise
identification of illiquid investments.
Article 23, concerning only leveraged AIF, could be a challenge depending on the chose level 2
and 3 measures to compute leverage.
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Risk Management in the Alternative Investment Fund Managers Directive

7. AIFM Directive – Risk Management – Conclusion & Next Steps
• Overall the AIFMD, does not restrict levels of risk to be taken by AIF however it
requires the setup of robust and formalized risk management on previously less
regulated Alternative Investment Funds.
• In turn the AIFMD implementation will require the setup of organization,
procedures and systems to match the requirements
• Over 2011, the EU Commission will be launching consultations to prepare level 2
and 3 measures through ESMA, which will provide insight on the future national law
and future CSSF guidelines
• With UCITS IV being implemented at national levels, and regulation on risk
management refined, we expect a convergence between UCITS risk management
requirements and AIFM requirements
• Although Level 2 & 3 implementation measures will be necessary to assess the full
details of requirements, AIFM are to start preparing now to avoid costly setup
later and in particular for funds launching over the coming months
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Risk Management in the Alternative Investment Fund Managers Directive

8. Contacts
Yoann Jagoury, CAIA, Partner in charge of Risk Management
For any further information please contact him by
Email: yoann.jagoury@altoadvisory.com or Phone +352 661 76 12 07
• Alto Advisory is a Luxembourg based consulting company specializing in risk
management and consulting for the asset management industry. Founded in 2009,
we provide our experience in products, processes and organization to major actors
of the asset management industry in Luxembourg and abroad.
• You can also visit our website: www.altoadvisory.com
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Risk Management in the Alternative Investment Fund Managers Directive